Mark February 27th, 2007 on your calendar. The day China’s Shanghai Composite Index tumbled 8.84 percent. For the record that is the largest one day decline in this market in a decade. More important than the size of the decline – 5% declines are not uncommon in this market - was its impact on the rest of the world. 

For clarity, it is important to recognize that not all Chinese stock markets panicked on February 27th. You might even argue that in the region, Shanghai was the exception rather than the rule. A case in point, Hong Kong’s blue-chip Hang Seng Index lost just 1.8% on the day. 

So what is the domestic Chinese (i.e. Shanghai) stock market? 

According to Jim Jubak of MSN Money, “the Shanghai stock market is essentially a domestic market for the A shares of China’s publicly traded companies: Overseas investors are by and large not allowed to buy and sell A shares (although the rules have been relaxed a bit lately).” The domestic market is made up of roughly 82 million Chinese investors or out of every twenty Chinese citizens. 

So what we witnessed was a mixture of naive investors getting their first taste of the fruits of capitalism. The Shanghai Stock Market has become, writes Jubal, “a stock speculator’s wildest dream come true, with that speculator’s worst nightmare waiting in the wings.” So much so that according to a recent study by J P Morgan Chase, of thirty seven Chinese companies listed on both the Shanghai and Hong Kong stock exchanges, eight traded in Shanghai at twice the valuation they had on the Hong Kong exchange.

The Chinese domestic market is supported by a sizeable individual investor base, who has access to easy money, is driven by irrational expectations while chasing a limited number of stocks. Not to mention the Chinese government, which at last count, owned the majority stake in most if not all publicly traded domestically listed companies. In retrospect the Shanghai Stock Market was at best, a frothy market in need of a healthy correction, at worst, a “rigged game.” Most likely, a bit of both.

Most analysts agree that the Feb 27th decline was orchestrated by the Chinese government. Perhaps with the best of intentions. According to John Maudlin of www.investorinsight.com, “the Chinese government was become increasingly concerned about levels of investment in its economy or, more accurately, the sheer amount of money that is chasing projects. State firms with limitless access to subsidized capital from state banks have used that access to launch thousands of nonprofitable firms.” 

What’s interesting says Mauldin, is that the “glut in [so-called] investment money drives up the cost of commodities and adds industrial capacity without actually producing anything of much use. In the end making life more difficult for the average Chinese and unduly harming relations with foreign powers that face a glut of otherwise noncompetitive Chinese goods.” 

So we end up with stock values that bear no relationship to the fundamentals. Not that China is the only market to experience excess valuations… remember the 1990s internet craze or the 15 year Japanese bull market that ended in 1989? 

Much like Japan, we are seeing supposedly blue chip Chinese banks trading at price-to-earnings ratios well above blue chip names like Deutsche Bank and Chase. Can you say excess? How else can you explain this unbridled enthusiasm for banks with woeful management, and a history of highly questionable lending practices. 

To China’s credit the government took notice. On February 26th, write Maudlin, “China’s State Council launched a new special task force that accurately could be referred to as the get-those-idiots-to-stop-borrowing-to-gamble-on-the-stock-exchanges team. Its express goal is to get the Chinese domestic security brokers to lay off such speculative decision-making, while also putting a crimp in the source of the subsidized capital.” 

In the West, we would expect it to be some time before a new committee would have an impact. But in China, results were immediate, which is understandable when you recognize that the government controls more than half the outstanding stock and therefore, controls supply and demand. If the Chinese government wants to take a shot across the bow - which is exactly what it did on February 27th - it simply sells more shares than the market can support. 

The problem, which I doubt the State Council anticipated, was the impact it would have on international markets. Writes Jubak, “China has become a trendsetter in the global stock community.” Whereas historically, the U.S. exchanges or EAFE set the tone for global trading patterns, you can now add China into the mix. And for the first time, global investors will have to deal a government that has a history of making domestic policy – on political and economic issues – with little regard as to how it might impact the rest of the world. 

Mind you, that could change. It is always easier to make decisions in a vacuum. But with Chinese market capitalization around US $1.3 trillion, the Chinese wall that protected international exchanges from Chinese policies is gone. February 27th was simply the exclamation point.

If China really believes that domestic growth is a serious domestic threat, then the Chinese government will take whatever action is necessary to slow things down. Look for more so-called shots across the bow, because the initial shot provided only a temporary reprieve as the Shanghai market actually ended higher on the week. 

Maudlin sees two potential problems. The rest of the world “is going to chew on the fact that Beijing did this intentionally. They will either agree with the Chinese that the exchanges are overvalued and that additional measures are needed, or they will be terrified that Beijing did this intentionally and not care about the reasons.” I lean more to the former than the latter.

Secondly, “trading in 800 of the 1,400 stocks on the Shanghai exchange was suspended during the sudden drops of Feb. 27.” They did not necessarily succumb to the sell-off. Does that mean they will have their day in the rain, or has the recovery of last week, dampened the risks of further decline. We will see. 

Of course for those of us who believe in the portfolio approach, global actions are less likely to drive us to make wrong decisions. We can read about the risks, but don’t have to experience the full brunt of the risks. Can you say diversification?